SEC’s newest marketing guidance sends managers back to drawing board

The Securities and Exchange Commission’s latest guidance on its marketing rules will send private equity managers back to the drawing boards as industry frustration with its regulator’s opacity mounts.

In a February 6 update to its Frequently Asked Questions page on the marketing rule – the first update regulators have published in more than a calendar year and only the fourth update since the commission adopted the sweeping new rules in late 2020 – the SEC says that any fund manager offering gross and net performance data in its public-facing documents must use “the same methodology” to calculate the two figures “over the same time period.”

“Although the marketing rule does not prescribe any particular methodology or calculation for performance,” the agency says in the new FAQ, “the rule requires that any presentation of gross performance be accompanied by a presentation of net performance that has been calculated over the same time period and using the same type of return and methodology as the gross performance. In addition, net performance must be presented in a format designed to facilitate comparison with gross performance.”

Fund managers cannot offer investors or potential investors a gross internal rate of return that leaves out fund borrowing (including sub lines) alongside only the net internal rate of return that factors fund borrowing in, regulators add. If fund managers wish to show investors or potential investors net IRR with fund-level sub lines factored, they must also either a.) show what the net IRR would be without the sub lines or b.) explain how those sub lines effect net IRR, regulators say.

“The staff believes that such a presentation would result in IRR calculations being made across different time periods (eg, gross IRR calculations beginning when funds initially use their lines of credit to acquire investments, and net IRR calculations beginning only once all capital commitments are called and the lines of credit are retired),” regulators say in the new FAQ. “Such a presentation would also violate the provision requiring presentations of performance in a format designed to facilitate comparison between net and gross performance.”

‘Ruin someone’s two months’

The new guidance may clarify how regulators see performance, but they’re likely to confuse private equity investors, says Igor Rozenblit, a former top SEC examiner who is now a partner at Iron Road Partners, a compliance consulting firm.

“It may be difficult to comply for some managers, because of the requirement to change active marketing materials,” he tells Private Funds CFO. “There are some large private equity managers with hundreds of active marketing materials and changing them all could ruin someone’s next two months.”

Among the problems with the new clarification, Rozenblit says, is that investors aren’t used to seeing data presented in the way regulators are now demanding it be presented.

“It’s going to force some managers to completely recast their net or completely recast their gross in a way that may confuse investors who are used to another approach,” he said. “I usually like the SEC’s approach but I don’t think this FAQ protects investors. This changes how private equity has done business for 30 years.”

“Many private equity managers think of gross performance as just the sum of all the investment cash flows in a fund,” Rozenblit added. “However, the new FAQ may change that. I think the easiest way to comply with the FAQ is to use capital calls less fees and expenses as the basis for ‘gross performance.’”

‘A lot of frustration’

When a unanimous SEC adopted the new marketing rules in the dying days of the Trump administration, some in industry welcomed them. The rules updated and replaced rules that in some cases hadn’t been updated since Kennedy was president. They were “principles-based,” meaning that they left room for fund managers to innovate and come up with answers on their own.

It’s true there were some early concerns about the rules’ substantiation requirements, and how broadly it construed “advertisement.” But industry advocates also assumed that regulators, as they traditionally had done, would help clean up corners with continuing guidance documents, including FAQs. In retrospect, it’s been a fatally false assumption.

“A lot of people are still just kind of guessing,” says Greg Larkin, a partner at Goodwin who has been ringing alarm bells about the new rules from the earliest days. “This new guidance doesn’t help much. The SEC may say that industry should’ve known all this on their own, but there’s a lot of frustration in industry right now because we’re not getting any meaningful guidance.”